Sovereign debt in turbulent times

It is a turbulent time for sovereign debt markets. Ever since the outbreak of the eurozone crisis, which rocked entire economies and brought governments crashing down, sovereign debt management has become a hotly debated topic among scholars and policymakers around the world. And even as the eurozone crisis cools down, the sovereign debt debate has been heating up in light of the recent legal victory of Argentina’s “holdout” creditors – a minority group of creditors who continue to hold bonds that Argentina defaulted on in 2001 and who refused to restructure those same bonds in the 2005 and 2010 debt exchanges.

While the eurozone debacle awakened policymakers to governance challenges of sovereign debt crises, Argentina’s Courtroom drama has raised fresh uncertainty around the legal aspects of sovereign debt as well as the attractiveness of New York as a financial hub. In trying to confront these challenges and quell uncertainty, the International Monetary Fund (IMF) has put forward a proposal to change its lending framework in a way that balances the interests of debtors and creditors and provides a workable solution to the seemingly intransigent problems at the core of sovereign debt crises.

At a broad level, the recent economic and legal developments in Europe and the United States have prompted a rethink of sovereign debt governance. Although sensitive to the needs and concerns of financial markets, states – especially the most powerful ones – are still in the driver’s seat when it comes to shaping the international sovereign debt regime.

The global consequences of the Argentina case, for instance, will depend on how states – primarily sovereign borrowers – respond to the new legal precedent that has been set. Sovereign borrowers may find it wise to re-write their bond contracts to include provisions that prevent or sterilize the type of legal action taken against Argentina. They may also increasingly move their business away from New York and choose to issue bonds under their own domestic laws or those of another foreign financial center. The fate of the IMF’s recently proposed change to its lending framework will also be determined by states; this time in a multilateral setting. Here, it will be up to the IMF’s executive board – its main decision-making body – to approve or reject the proposal when it comes up for review later this year.

In both cases – Argentina’s legal saga and the IMF’s proposed reforms – the preferences of market participants may very well influence the decision-making of states (especially those reliant on borrowing from international markets or those with their own advanced and globalized financial markets).

The eurozone crisis kicked off in 2009 when the newly elected Greek government revealed that the reported fiscal deficit of 6.5% of GDP was actually double that. Unsurprisingly, Greece’s borrowing costs spiked and its bonds were downgraded, compounding the underlying debt problem. Moreover, as the economy set itself on a downward spiral, the ratio of debt-to-GDP rose.

Before long, trouble started to spread to other economies in the eurozone’s periphery. Governments in Portugal, Ireland, Spain, and Italy saw borrowing costs rise as investors began to sell what now appeared to be risky sovereign bonds to cover the losses incurred on their Greek debt holdings. At the time, the IMF, in concert with the EU Commission and the European Central Bank, was compelled to act in order to stave off a deeper and wider financial collapse in Greece and the rest of the euro zone.

It was clear that Greece would need a lot of money and a lot of help, but according to the “exceptional access” lending criteria, the IMF could only lend to Greece if there was a “high probability” of the country’s debt being sustainable over the medium term. The problem: there was not. Still, the IMF wanted to help resolve the crisis and was under mounting pressure from its powerful European members to get involved.

Normally a country like Greece –whose debt could not be deemed sustainable with high probability – would be required to restructure before accessing large-scale IMF resources. But when faced with the early spillover effects from Greece and the heightened potential for debt defaults and restructurings to trigger contagion in a tightly-linked economic and monetary union, the Fund decided to offer Greece a bailout while avoiding restructuring.

To enable the Fund to lend to Greece in the absence of a restructuring, the executive board approved in 2010 an amendment to the exceptional access framework, allowing the “debt sustainability” criteria to be waived in cases where there is a “high risk of international systemic spillover effects,” as our CIGI colleague Susan Schadler has highlighted in her research.

Unfortunately, the combination of external support and internal adjustment provided by the IMF bailout failed to put Greece’s public debt back on a sustainable footing; in fact, its economy and debt position only continued to deteriorate. In 2012, the inevitable could no longer be forestalled: Greece underwent the largest sovereign default and debt restructuring in history (surpassing Argentina’s historic 2001 default).

Even though it achieved very large debt relief – more than 50% of 2012 GDP – the restructuring was not enough to restore growth and debt sustainability. In retrospect, the Fund admitted that the Greek restructuring was “too little, too late.” If some debt restructuring had been required at the beginning of the crisis, as the Fund’s pre-2010 lending rules specified, Greece’s return to economic health could have been much sooner and stronger. It was not. The Fund also conceded that its lending framework, even before the 2010 amendment, was not optimally designed to deal with cases where there is considerable uncertainty regarding the sustainability of a country’s public debt.

Aside from failing to restore growth and debt sustainability, the Greek debt restructuring came at a cost in terms of holdout creditors. While the Greek restructuring enjoyed a high rate of participation among bondholders (97%), those who refused to participate were successful in recovering their investments in full, which only strengthens the incentive for others to hold out from future deals.

Since January 1, 2013, all new euro zone sovereign bonds have been required to include “collective action clauses” (CACs),which are supposed to facilitate creditor coordination and render holdouts less effective. But evidence on the actual effectiveness of CACs in past debt restructurings is mixed and thus inconclusive. Moreover, CACs do nothing to address the “too little, too late” problem– a problem that many now consider more challenging than holdout creditors.

Further still, as economists Carmen Reinhart and Ken Rogoff point out, underlying debt dynamics suggest that in the coming years more sovereign debt restructurings will prove necessary in the eurozone’s periphery. Other advanced economies do not look much better, for that matter, as central government debt across the developed world reaches a 200-year highpoint. The message from the eurozone crisis is thus clear: sovereign debt crises, which now affect relatively rich societies, are not going away anytime soon nor getting any easier to handle. This realization has sparked serious discussion and debate, both inside and beyond the Fund’s walls, about how to best prevent and manage such crises going forward.

The ongoing sovereign debt debate has only been revved up by the recent legal battle between Argentina’s central government and a small group of “holdout” creditors, led by New York-based hedge fund Elliot Management, who refused to participate in either of the country’s post-2001 restructurings. In June 2014, the Supreme Court of the United States (the country in which Argentina’s bonds were issued) had the final word in the dispute, denying Argentina’s request to hear an appeal of a lower-court ruling in favor of the holdouts.

Based on a particular interpretation of the pari passu (equal treatment) clause contained in Argentina’soriginal bonds, the ruling specified that Argentina cannot makepayments on the debt it restructured in 2005or 2010 unless it also repays in full the creditors who refusedto partake in those restructurings. Even thoughthe vast majority of bondholders agreed to the debt exchangesand the country was able to restructure over90% of its debt, if Argentina complies with the court’sruling it could be required to pay around $15 billion toholders of defaulted bonds.

The problem with the court’s decision, beyond the severe financial strain it puts on Argentina, is that it sets a legal precedent under New York law – the law governing a large portion of sovereign bonds – that threatens to make restructuring unsustainable sovereign debt more difficult than it already is. By ruling that Argentina’s holdout creditors, many of whom bought their bonds on secondary markets after default and at a deep discount, must be repaid in full if anyone is to be repaid at all, the court’s decision has rewarded recalcitrant creditors – referred to pejoratively as “vulture funds” – and punished cooperative ones, thus creating a perverse incentive for all creditors to holdout from future restructurings.

As a recent IMF staff paper put it, “by allowing holdouts to interrupt the flow of payments to creditors who have participated in the restructuring, the decisions would likely discourage creditors from participating in a voluntary restructuring” and “by offering holdouts a mechanism to extract recovery outside a voluntary debt exchange, the decisions would increase the risk that holdouts will multiply and creditors who are otherwise inclined to agree to a restructuring may be less likely to do so due to inter-creditor equity concerns.”

As The Economist commented, strict adherence to the pari passu clause “would make restructuring sovereign debt sold in New York impossible, since no one could be paid without 100% participation in a swap.” Clearly, then, the decision has potentially made restructurings much harder to agree to, let alone enforce. For those who believe that restructuring unsustainable sovereign debt needs to be made quicker and easier, the generous treatment of Greece’s holdouts during the 2012 restructuring and the legal ruling in favor of Argentina’s holdouts are most unwelcome developments.

The outbreak of the euro zone crisis, combined with the legal saga surrounding Argentina’s debt obligations, has put sovereign debt restructuring at the top of the IMF’s agenda. In June 2014 the IMF released a staff report considering a new approach to Fund’s “exceptional access” lending framework as it relates to sovereign debt restructuring. The report identifies key deficiencies in the Fund’s current lending framework – brought into stark relief during the eurozone crisis – and outlines a new, potentially improved, institutional approach to managing sovereign debt crises.

Established in 2002 and amended in 2010, the current framework stipulates that in cases where there is a “high risk of international systemic spillover effects,” a member’s debt sustainability does not have to be assured to gain exceptional access to IMF resources. The wisdom of introducing this “systemic exemption” in 2010 has since been scrutinized, as critics argue that it undermined the framework’s ability to constrain IMF lending decisions to the ultimate detriment of the Fund’s legitimacy and ability to manage future crises. Whether or not the Fund heeded such criticism, the first major recommendation of the June 2014 staff paper is to eliminate the “systemic exemption.”

If the “systemic exemption” is removed, the Fund is left with its 2002 framework, which states that in order to be granted exceptional access to IMF resources, a rigorous and systematic analysis must indicate with “high probability” that a member’s public debt will remain sustainable in the medium term. If debt sustainability can be assured with high probability, the Fund will rely on its traditional approach: provide money to repay creditors with maturing debt obligations (i.e., to bailout creditors) as long as the borrowing country agrees to an economic adjustment program.

If a country’s debt sustainability cannot be assured with high probability, however, it must undergo a debt restructuring sufficiently deep to restore sustainability before it can receive IMF assistance. As a consequence of this approach, “debt restructuring will be required not only in cases where there is a high probability of unsustainability, but also where it is not clear with a high probability whether the debt is sustainable or unsustainable; i.e., in cases where there is uncertainty.”

The problem with this approach is that, despite the increasing sophistication of the Fund’s debt sustainability analyses (DSAs), there are many cases in which considerable uncertainty exists; in these cases, requiring a deep debt restructuring, which imposes steep costs on creditors and debtors, may be an unnecessary and suboptimal outcome. As such, in cases of uncertainty, where neither the sustainability nor the unsustainability of a member’s debt can be established with “high probability,” Fund staff advocate an approach that relies on reprofiling debt rather than restructuring it.

Under a reprofiling, there would be an extension of maturities on existing sovereign debt, but no change to the nominal interest or principal. According to IMF staff, in cases of genuine uncertainty, reprofiling sovereign debt would be more effective than the current crisis management strategy for at least four reasons: (1) it would be less disruptive to financial markets and less costly to debtors and creditors than a potentially unnecessary debt restructuring; (2) it would be more effective and fair than allowing creditors with maturing claims to “exit” if a debt restructuring does indeed prove necessary; (3) it would buy more time to implement necessary policy adjustments, better assess debt sustainability as those policies go into effect, and, in turn, reduce the likelihood of needing a restructuring in the first place; and (4) since Fund resources would not have to be used to service maturing debt obligations, the IMF could support a more growth-friendly (i.e., less austerity-based) adjustment program with a greater chance of restoring debt sustainability.

In addition to genuine uncertainty, reprofiling would be conditional upon a member country already having lost market access; that way, reprofiling would follow, not trigger, a loss of confidence or certainty in a country’s debt sustainability. Fund staff also note the importance of securing broad creditor support for a reprofiling, and thus the need to implement reprofiling in a way that, if possible, avoids a payment default.

Overall, the Fund is seeking a broader range of economically potent and politically acceptable policy tools for managing severe sovereign debt crises. Compared to the status quo, argue IMF staff, providing a greater role for debt reprofiling in the IMF’s exceptional access lending framework will allow the Fund to better tailor its policy actions to the specific circumstances of a given country and crisis.

The IMF’s proposal is far from the only new idea for how to improve the handling of severe sovereign debt crises. In fact, the last few years have seen several new noteworthy proposals. Experts from the Bank of Canada and the Bank of England propose the introduction of two complementary types of “state-contingent debt” – “sovereign cocos” and “GDP-linked bonds.” The former are bonds that would automatically extend in maturity when a country receives an IMF loan; the latter are bonds that directly link principal and interest payments to the nominal level of a country’s GDP, so when its GDP falls, so too do its debt servicing payments.

Our CIGI colleagues Richard Gitlin and Brett House advance the idea of a Sovereign Debt Forum (SDF): a semi formal institutional venue that would, in the words of its architects, “provide…a venue for proactive discussions between debtors and creditors to reach early understandings on treating specific sovereign crises.” A group of distinguished economists and sovereign debt experts known as The Committee on InternationalEconomic Policy and Reform have also tabled a series of proposals, ranging from strengthening sovereign bond contracts and immunizing payments on restructured debt from “interference” by holdout creditors, to creating a new lending facility at the IMF and a formal international bankruptcy regime in Europe.

In many ways, reprofiling would have much the same effect as something like sovereign cocos. The main difference between any of the proposals mentioned above and the one developed by the IMF, however, is that the Fund’s proposal already enjoys the internal support of its staff and management, who are in a position to bring their recommendations directly to the executive board for formal review and consideration. And since the Fund is itself a key actor in global financial governance, if its member states vote to reform the institution’s lending framework, it may have an impact on the governance of sovereign debt crises.

Summing up, the recent economic and legal developments in sovereign debt markets have prompted a rethink of sovereign debt governance. The choice to chart a new course in debt governance lies with the states that comprise the IMF’s membership. Collectively, these states can redefine the Fund’s role in sovereign debt crises. Individually, they can ensure that their own bonds are issued in favorable legal jurisdictions and with more protective legal provisions. If states choose to take such actions, it will have a transformative – and arguably positive – impact on the functioning of sovereign debt markets and the management of sovereign debt crises.

Domenico Lombardi isDirector of the Global Economy Program at the Centre for International Governance Innovation (CIGI), Canada.

Skylar Brooks is a research associate in the Global Economy Program at CIGI.

"The outbreak of the euro zone crisis, combined with the legal saga surrounding Argentina’s debt obligations, has put sovereign debt restructuring at the top of the IMF’s agenda."

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

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